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CHAPTER 7: PRODUCT DIFFERENTIATION AND MONOPOLISTIC COMPETITION

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The chapter considers models with products that are homogeneous (perfect substitutes) or with low-degree differentiation (good substitutes).

2. The market structure is monopolistic competition in which firms can freely enter and exit The case of highly differentiated products with few substitutes is more interesting. 4. Markets with highly differentiated markets are not monopolistically competitive. The high degree of differentiation creates a (temporary) barrier to entry.

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DEFINITIONS Product Differentiation: Related products that have varying characteristics so that consumers do not view them as perfect substitutes. Products are differentiated if there is some identical price for each product in which some consumers are willing to purchase one product over another. Horizontal Differentiation: Differences between products that increase perceived benefit for some consumers but decrease it for others. Vertical Differentiation: Distinction of a product that makes it better than the products of competitors. Differentiation Advantage: One of the major strategies to achieve competitive advantage (positive economic profits). When pursuing a differentiation advantage, firms seek to offer a higher perceived benefit while maintaining costs that are comparable to competitors (consumer surplus and producer surplus increase and consequently welfare [= CS + PS] will increase).

Successful competitive advantage increases value (B – C), allows consumers to capture some increased value (B – P), [otherwise they do not purchase the product], and increases profit for the firm (P – C) [otherwise do not seek competitive advantage]. Firms may not pursue competitive advantage (and therefore society loses some welfare) if the advantage cannot be sustained for some time period. Sustainable competitive advantage requires forces that limit the extent to which the advantage can be duplicated or neutralized. Two groups of mechanisms: 1. Impediments (barriers) to imitation 2. Early-mover advantages Trade-off: Product differentiation may increase welfare by increasing value (the good part), but to make it sustainable requires some barriers to entry and worsens market structure (the bad part).

MODEL 1: Representative Consumer Model In this model the consumers are alike and view all products as equally good substitutes. With monopolistic competition there is free entry. Case 1: Undifferentiated Products Each of the n firms shares the market demand equally and gets (1/n) share of the demand. The number of firms, n, is determined by making n just large enough to yield zero economic profits. Results: 1. Lower FC increases the number of firms, increases market output and lowers market price. 2. P > MC (allocative inefficiency) – too little total output. Efficiency, in a sense, improves as more firms enter. 3. Number of firms is excessive when MC are nonincreasing (natural monopoly case) 4. Better result than the Cournot oligopoly model with barriers to entry

Case 2: Differentiated Products The essence of the model remains the same as the undifferentiated case. However, each firm faces a more steeply downward sloping demand curve. (reflects a higher CS from the differentiation) Results: 1. P > MC (allocative inefficiency) – too little total output. 2. Variety (number of brands) may not be optimal. 3. May be too little variety (brands) • FC are too high and firms lose money (p < AC)
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Firm creates value (increases welfare) but is unable to capture sufficient CS to make a profit – does not produce

• Need impediments to imitation so that firms can charge a higher price to cover AC – or provide a “prize” to innovators for their discoveries leading to differentiation 4. May be too many brands
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With free entry firms enter until profit is exhausted

• Firms entering have a negative external effect on other firms profit (PS) • Welfare may decrease with too many brands • CS increases are smaller that PS decreases
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Also have additional FC with each new brand

5. As before price is too high (p > MC) Inference: Differentiation may require barriers to imitation to be welfare enhancing.

Hotelling’s Location (Spatial) Model This model is an example of horizontal differentiation. It can be extended to other forms of differentiation along a (linear) dimension. Consider the case of two firms deciding where to locate on a street with uniformly distributed consumers. You could think of this as a zero-sum game. Consider the Sales from two Ice Cream trucks. Other Truck Beginning Waldman Location Beginning Middle End 50, 50 75, 25 50, 50 Middle 25, 75 50, 50 25, 75 End 50, 50 75, 25 50, 50

1st number is Waldman payoff, 2nd number is other truck payoff Or characterized as Other Truck Beginning Waldman Location Beginning Middle End 0 25 0 Middle -25 0 -25 End 0 25 0

Number is change in Waldman share. Negative of number is change in other truck share This is a dominant strategy equilibrium game, with each player choosing the action that is the best response against any action the other might take. Look for dominant strategies in the game above. Other Truck Beginning Waldman Location Beginning Middle End 50, 50 75, 25 50, 50 Middle 25, 75 50, 50 25, 75 End 50, 50 75, 25 50, 50

The dominant strategy for each player in this zero sum game is to locate the truck in the middle. The two firms will cluster together in the middle (no spatial differentiation), when there is no cost to locating. This is the Bertrand equilibrium with homogenous products.

Alternatively, if the stores are located apart with costly relocation, we get the Bertrand equilibrium with differentiated products. 1. 2. 3. P > MC Differentiation softens the price competition Differentiation gives firms market power

ISSUES The Federal Trade Commission (FTC) often considers two issues when deliberating; (i) (ii) Is competition lessened? Are consumers harmed?

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Should firms pursuing competitive advantage with a differentiation be considered bad behavior or good? 2. Patents provide an impediment (barrier) to imitation as a reward for innovation (which leads to differentiated products). (i) (ii) If the FC for innovation is low should a patent be issued? If the FC is high should a patent be issued?

3. Is price collusion more likely or less likely with differentiation? What if the differentiation is vertical (based on quality)?